Freda v. Commissioner

656 F.3d 570 (7th Cir. 2011)

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Nature of the Case

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Facts

P is a meat processing company that developed a process for making and freezing pre-cooked sausage that had the appearance and taste of home-cooked sausage. P obtained a patent protecting its new process. P treated as trade secrets all subsequent refinements to the process. Pizza Hut, expressed an interest in using sausage made pursuant to P's process. P had to agree to share the process with Pizza Hut's other sausage suppliers so that Pizza Hut could offer its customers a uniform product. Pizza Hut and P signed an agreement pursuant to which P disclosed the information and Pizza Hut promised to keep them a secret. P entered licensing agreements with several of Pizza Hut's other suppliers, disclosing its C&F process in exchange for promises of confidentiality and licensing fees. Pizza Hut failed to buy sufficient quantities of sausage from P and divulged crucial information to IBP, Inc., another meat processing company with whom P had not signed a confidentiality or licensing agreement. IBP replicated the process, set its prices below P's, and began selling large quantities of sausage to Pizza Hut. Pizza Hut bought less and less sausage from P. P filed suit against both Pizza Hut and IBP alleging that Pizza Hut misappropriated its trade secrets. P claimed lost profits, lost opportunities, operating losses, and expenditures. P's trade secret misappropriation claim against IBP proceeded to trial and a jury awarded P $10.9 million in damages. P determined that it would have had approximately $2.86 million in additional profits if IBP had not misappropriated its trade secret; it treated that portion of its take-home from the settlement as ordinary income and the rest as capital gain on its 2000 federal income taxes. Pizza Hut settled the trade secret misappropriation claim for $15.3 million in January 2002. After deducting attorneys' fees, expenses, and a sizeable payment to a former shareholder (who redeemed his shares to P in exchange for an interest in the suit) from the settlement, P walked away with $6.12 million. P characterized the $6.12 million as gain from a 'trade secret sale' and reported the entire amount as long-term capital gain on its 2002 federal income tax form. D issued notices of deficiency to the shareholders after determining that the settlements were ordinary income. Ps are the shareholders who were denied capital gains treatment of the funds. The Tax Court agreed with D and Ps appealed.